Market economies are influenced by monetary policy and the business cycle, with governments able to influence the latter through the former. However, loose monetary policy can lead to inflation and a contraction in the economy, resulting in declining supply and demand.
An economy is a vast conglomeration of individuals, businesses, regulations, government policies, and phenomena. Two important aspects of a market economy are monetary policy and the business cycle. The former represents government policies related to the money supply and interest rates, while the latter is a natural cycle of phases, from growth to peak, contraction to depression. While a market economy naturally goes through each stage, governments can influence the business cycle through the use of monetary policy, hence a direct relationship between the two. Unfortunately, monetary policy and the business cycle can have unintended negative effects.
Market economies rely primarily on individuals and businesses residing in the general locale to move resources between users. Growth occurs naturally as the demand for goods or services for specific items increases. Inflation, which is classically defined as too many dollars chasing too few goods, can occur as a result of growth. This can rectify itself when suppliers can increase the supply side of the economic equation. Monetary policy and the business cycle tend to start their relationship in the growth phase.
Governments may decide to induce growth through the use of a central bank or other economic agency that sets monetary policy. By increasing the money supply through low bank retention rates and low interest rates, growth can begin due to ease of access to money. Businesses can expand and individuals have the ability to purchase more goods or more expensive goods than before established policies. However, a difficulty arises because unnatural inflation can result from loose monetary policy and the business cycle begins to peak early. An initial spike in the growth phase means that businesses cannot expand and prices may rise on goods due to lower supply and stable or higher demand due to rising levels of money for individuals to purchase of goods.
The result of loose monetary policy and rampant inflation can lead to a government having to tighten monetary policy. The only way to complete this is to reverse loose monetary policies, which means high bank retention rates for money held and higher interest rates for loans. The result is less money in the overall market economy by which individuals and firms can purchase resources or goods, respectively. In this case, monetary policy and the business cycle can cause a contraction starting with declining supply and demand. Businesses could begin to liquidate, and individuals will not have the same purchasing power as fewer dollars limit their ability to buy luxury – unnecessary items – in the economy.
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